1. Chapter 9 Accounting for Receivables Adapted for Accounting 211 Professor John Ahmad

2. Overview and Teaching Objectives for Today’s Session 1 Distinguish between the methods and bases used to value accounts receivable 2 Describe the entries to record the disposition of accounts receivable 3 Compute the maturity date of and interest on notes receivable 4 Explain how notes receivable are recognized in the accounts 5 Describe how notes receivable are valued 6 Describe the entries to record the disposition of notes receivable 7 Explain the statement presentation and analysis of receivables

3. Amounts due from individuals and other companies – claims expected to be collected in cash Three major classes of receivables are 1 Accounts Receivable - amounts owed by customers on account 2 Notes Receivable - claims for which formal instruments of credit are issued 3 Other Receivables – - non-trade receivables Examples: interest receivable and advances to employees RECEIVABLES STUDY OBJECTIVE 1

4. Three primary accounting issues with accounts receivable: 1 Recognizing accounts receivable. 2 Valuing accounts receivable. 3 Disposing of accounts receivable. ACCOUNTS RECEIVABLE

5. RECOGNIZING ACCOUNTS RECEIVABLE STUDY OBJECTIVE 2 When a business sells merchandise to a customer on credit, Accounts Receivable (an asset account) is debited and Sales (a revenue account) is credited. July 1 Accounts Receivable – Polo Co. 1,000 Sales 1,000

6. RECOGNIZING ACCOUNTS RECEIVABLE When a business sells merchandise to a customer on credit, Accounts Receivable is debited and Sales is credited. When a business receives returned merchandise previously sold to a customer on credit, Sales Returns and Allowances (a contra-revenue account) is debited and Accounts Receivable (an asset account) is credited. July 5 Sales Returns and Allowances 100 Accounts Receivable – Polo Company 100

7. RECOGNIZING ACCOUNTS RECEIVABLE When a business sells merchandise to a customer on credit, Accounts Receivable is debited and Sales is credited. When a business collects cash from a customer for merchandise previously sold on credit during the discount period, Cash (asset) and Sales Discounts (contra revenue) are debited and Accounts Receivable (asset) is credited. 882 18 900

8. Cash (net) realizable value –net amount expected to be received in cash and excludes amounts that the company estimates it will not be able to collect Credit losses –debited to Bad Debts Expense –considered a normal and necessary risk of doing business. Two methods of accounting for uncollectible accounts are: 1 Direct write-off method 2 Allowance method VALUING ACCOUNTS RECEIVABLE STUDY OBJECTIVE 3

9. Direct write-off method –Bad debt losses are not anticipated and no allowance account is used –No entries are made for bad debts until an account is determined to be uncollectible at which time the loss is charged to Bad Debts Expense No matching with the date the receivable was initially recorded, which could be in another period No determination how much value of accounts receivable on the balance sheet can be realized into cash Therefore, the direct write-off method is not acceptable for financial reporting purposes DIRECT WRITE-OFF METHOD

10. Journal Example Warden Co. writes off M. E. Doran’s $200 balance as uncollectible on December 12. When this method is used, Bad Debts Expense will show only actual losses from uncollectible amounts without regard to when the account become uncollectible! Not acceptable under GAAP! Dec. 12 Bad Debts Expense 200 Accounts Receivable – M.E. Doran 200

11. Allowance method –required when bad debts are deemed to be material in amount. Uncollectible accounts are estimated –expense for the uncollectible accounts is matched against sales in the same accounting period in which the sales occurred. THE ALLOWANCE METHOD

12. Estimated uncollectibles are debited to Bad Debts Expense and credited to Allowance for Doubtful Accounts at the end of each period. THE ALLOWANCE METHOD Dec. 31 Bad Debts Expense12,000 Allowance for Doubtful Accounts 12,000

13. Actual uncollectible amounts are debited to Allowance for Doubtful Accounts (contra-asset) and credited to Accounts Receivable (asset) at the time the specific account is written off. Bad debt expense is not debited again because we have already recognized it! THE ALLOWANCE METHOD Mar. 1 Allowance for Doubtful Accounts 500 Accounts Receivable - R. A. Ware 500

14. If there is recovery of an account that has been written off: First: reverse the entry made to write off the account and... THE ALLOWANCE METHOD July 1 Accounts Receivable – R. A. Ware 500 Allowance for Doubtful Accounts 500

15. THE ALLOWANCE METHOD Second: Record the collection in the usual manner. July 1 Cash 500 Accounts Receivable 500

16. Companies use one of two methods in the estimation of uncollectible amounts: 1 Percentage of sales 2 Percentage of receivables Both bases are OK under GAAP; the choice is a management decision. BASES USED FOR THE ALLOWANCE METHOD

17. COMPARISON OF BASES OF ESTIMATING UNCOLLECTIBLES Percentage of Sales Percentage of Receivables Emphasis on Income Statement Emphasis on Balance Sheet Relationships Relationships Again, the decision is management’s.

18. Management estimates what percentage of credit sales will be uncollectible. Expected bad debt losses are determined by applying the percentage to the sales base of the current period. This provides a better match of expenses with revenues. Let’s look at an example on the next slide… OPTION 1 - PERCENTAGE OF SALES BASIS

19. PERCENTAGE OF SALES BASIS If net credit sales for the year are $800,000, the estimated bad debts expense is $8,000 (1% X $800,000). Note: any balance in Allowance for Doubtful Accounts is disregarded. Dec. 31 Bad Debts Expense 8,000 Allowance for Doubtful Accounts 8,000

20. Management estimates what percentage of receivables will result in losses from uncollectible accounts Amount of the adjusting entry is: – the difference between the required balance and the existing balance in the allowance account Produces the better estimate of cash realizable value of receivables… Let’s look at Ill. 9-7 p. 370 OPTION 2: PERCENTAGE OF RECEIVABLES BASIS

21. Illustration 9-7, p. 370 Note: we need to adjust Allowance for Doubtful Accounts to the needed level of $2,228. Let’s see how we do it on the next slide.

22. PERCENTAGE OF RECEIVABLES BASIS If the trial balance shows Allowance for Doubtful Accounts with a credit balance of $528, an adjusting entry for $1,700 ($2,228 - $528) is necessary. Also called aging the accounts receivable. Remember, accounts receivable is a permanent account. This is why it may have a balance from the preceding accounting period! Dec. 31 Bad Debts Expense 1,700 Allowance for Doubtful Accounts 1,700

23. Companies frequently dispose of accounts receivable in one of two ways: 1 sell to a factor such as a finance company or a bank (a factor buys receivables from businesses for a fee and collects the payments directly from customers) ….. OR…… 2 make credit card sales (a credit card company is also a factor) DISPOSING OF ACCOUNTS RECEIVABLE STUDY OBJECTIVE 4

24. SALE OF RECEIVABLES Hendrendon Furniture factors $600,000 of receivables to Federal Factors, Inc. Federal Factors assesses a service charge of 2%of the amount of receivables sold. Cash 588,000 Service Charge Expense (2% x $600,000) 12,000 Accounts Receivable 600,000

25. Credit cards –used by retailers who wish to avoid the paperwork of issuing credit –cash is received quickly from the credit card issuer National credit cards –Visa, MasterCard, Discover, and American Express CREDIT CARD SALES

26. Three parties 1 credit card issuer 2 retailer 3 customer Retailer pays the credit card issuer a fee of 2-6% of the invoice price for its services. From an accounting standpoint, sales from Visa, MasterCard, and Discover are treated differently (as cash)than sales from American Express (as an accounts receivable). CREDIT CARD SALES

27. VISA, MASTERCARD, AND DISCOVER SALES VISA, MasterCard, and Discover –cards issued by banks –considered cash sales by the retailer Upon receipt of credit card sales slips from a retailer the bank immediately adds the amount to the seller’s bank balance (see next slide for example)

28. VISA, MASTERCARD, AND DISCOVER SALES Anita Ferreri purchases a number of compact discs for her restaurant from Karen Kerr Music Co. for $1,000 using her VISA First Bank Card. The service fee that First Bank charges is 3%. Cash 970 Service Charge Expense 30 Sales 1,000

29. AMERICAN EXPRESS SALES American Express cards –reported as credit sales, not cash sales Conversion to cash does not occur until the American Express remits the net amount to the seller.

30. AMERICAN EXPRESS SALES Four Seasons Restaurant accepts an American Express card for a $300 bill. The service fee that American Express charges is 5%. Accounts Receivable – American Express 285 Service Charge Expense 15 Sales 300

31. Promissory note –written promise to pay a specified amount of money on demand or at a definite time. Maker –The party making the promise. Payee –The party to whom payment is made. NOTES RECEIVABLE

32. The life of the note expressed in terms of months – the due date is found by counting the months from the date of issue Example: The maturity date of a 3 month note dated May 31 is August 31. NOTES RECEIVABLE

33. If the life of the note is expressed in terms of days –you need to count the days. –the date of issue is omitted but the due date is included. Example: The maturity date of a 60-day note dated July 17 is: DETERMINING THE MATURITY DATE STUDY OBJECTIVE 5 – Handout 1 Term of note 60 July 31– 17 14 August 31 45 Maturity date: September 15

34. The basic formula for computing interest on an interest-bearing note is: The interest rate specified on the note is an annual rate of interest. FORMULA FOR COMPUTING INTEREST (Handout 2) Face Value of Note Annual Interest Rate Time in Terms of One Year Interest X X =

35. Helpful hint:The interest rate specified is the annual rate. $ 730 X 18% X 120/360 = $ 43.80 $1,000 X 15% X 6/12 = $ 75.00 $2,000 X 12% X 1/1 = $240.00 COMPUTATION OF INTEREST

36. RECOGNIZING NOTES RECEIVABLE STUDY OBJECTIVE 6 Wilma Company receives a $1,000, 2-month, 12% promissory note from Brent Company to settle an open account. We record it at its face value. May 1 Notes Receivable 1,000 Accounts Receivable – Brent Company 1,000

37. Like accounts receivable, short-term notes receivable are reported at their cash (net) realizable value. The notes receivable allowance account is Allowance for Doubtful Accounts. VALUING NOTES RECEIVABLE STUDY OBJECTIVE 7

38. HONOR OF NOTES RECEIVABLE STUDY OBJECTIVE 8 A note is honored when it is paid in full at its maturity date. For an interest-bearing note, the amount due at maturity is the face value of the note plus interest for the length of time specified on the note. Betty Co. lends Wayne Higley, Inc. $10,000 on June 1, accepting a 5-month, 9% interest-bearing note. Betty Co. collects the maturity value of the note from Higley on November 1 (five months from the issue date). The entry to record is shown above. 10,300 10,000 375

39. HONOR OF NOTES RECEIVABLE If Betty Co. prepares prepares financial statements as of September 30, interest for 4 months, or $300, would be accrued under the matching principle. The entry to record shown above: $10,000 X 9% X 4/12 = $300 300

40. HONOR OF NOTES RECEIVABLE When interest has been accrued, it is necessary to credit Interest Receivable at maturity, because it it now being paid. Interest Revenue is the amount earned in the fifth month. 10 375 10,000 300 75

41. DISHONOR OF NOTES RECEIVABLE A dishonored note is a note that is not paid in full at maturity. A dishonored note receivable is no longer negotiable. Since the payee still has a claim against the maker of the note, the balance in Notes Receivable is usually transferred to Accounts Receivable because it is due immediately. Oct. 1 Accounts Receivable 10,375 Notes Receivable 10,000 Interest Revenue 375

42. BALANCE SHEET PRESENTATION OF RECEIVABLES STUDY OBJECTIVE 9 In the balance sheet, short-term receivables are reported in the current assets section below short- term investments. Report both the gross amount of receivables and the allowance for doubtful accounts. Remember, the more liquid the account, the earlier it is reported on the balance sheet!

43. ACCOUNTS RECEIVABLE TURNOVER RATIO AND COMPUTATION Ratios are computed to evaluate the liquidity of a company’s accounts receivable Accounts receivables turnover ratio used to assess the liquidity of the receivables If Cisco had net credit sales of $18, 915 million for the year and beginning net accounts receivable balance of $1,466 million and ending net accounts receivable balance of $1,105 million: $18,915/ ($1,466 + $1,105)/2 = 14.7 times Net Credit Sales Average Net Receivables Accounts Receivable Turnover /=

44. AVERAGE COLLECTION PERIOD FOR RECEIVABLES FORMULA AND COMPUTATION An alternate presentation of the turnover ratio that makes liquidity even more evident. We do this by dividing the turnover ratio into 365 days. The general rule is that the collection period should not exceed the credit term period. Cisco’s turnover ratio is computed as: Days in Year/AR Turnover = Average Collection Period in Days 365 days / 14.7 times = 24.8 days

45. Homework for Chapter 9